Policy | Security | Investigation

online

November 25, 2009

If a public organization doesn't embrace transparency, transparency will be thrust upon it forcibly. For any institution, its electronic records are so detailed and subject to revelation in so many ways that the institution must find a way to pre-empt their inopportune public disclosure. Better to come clean with information now – before the lawsuit (think deposition) or the FOIA request or the hacker break-in brings the information to light.

The climate research unit at the University of East Anglia is learning directly how disconcerting unexpected disclosure can be. Someone – whether an outside hacker spy or an inside whistleblower – has leaked volumes of e-mails, software, source code and programmer notes to the world. As a world leader on climate modeling, the university is shocked to see its internal discussions hung out for public scrutiny.

Some emails suggest the university's scientists had earlier tried to destroy records to prevent their disclosure under a freedom of information request. Other records arguably depict programmers manipulating data for key climate modeling software in a deceptive manner. Some emails appear to show researchers misallocating expenses against a US government research grant.

Some observers speculate all these records had been assembled for a freedom of information request, and after the request was denied, an internal whistleblower elected to liberate them. Once information leaves the confines of the institution, it's easy to broadcast through channels like Wikileaks.com.

Separately, another institution on which technology has violently imposed transparency is international banking. An IT staffer at LGT Group stole secret bank customer records and sold them to the German tax authorities, who used them to prosecute tax evaders. “Liechtenstein Under Siege Clings to Bank Secrecy to Outdo Swiss,” Bloomberg.com 2/27/08.

Then a US Senate investigative committee data-mined Homeland Security records of foreign visitors to uncover a pattern of Swiss bankers coming to the US illegally to solicit deposits from rich American taxpayers. These unsavory revelations -- made possible by new technology -- has devastated the long-standing industry of secret bank accounts in places like Switzerland. The US has largely closed down that industry as an avenue for tax evasion and other crime. Kevin McCoy, “IRS: Offshore tax crackdown should produce 'billions',” USA Today, Nov. 17, 2009.

So in this technological age of leaks and sousveillance, what are institutions to do? Here are three mild examples of proactive transparency:

* New York City allows web-empowered citizens to track their government's performance on details like response times on calls to the fire department or the street maintenance crews.

* The City lets the same citizens monitor how the city is spending federal stimulus dollars.

* 15 local governments in South Carolina now post their full check registers online so citizens can scrutinize how the governments spend cash and which vendors get how much money.

Update November 29, 2009: After thinking about it, the University of East Anglia has decided that radical transparency is the only logical policy. In the wake of the hacker break-in described above, the University has announced it will reveal "all" of its climate data as soon as possible.

The World Wide Web is changing contract and commercial law practices. As a global medium for broadcasting terms, notices, conditions, and disclaimers, the web empowers business innovators preemptively to warn their trading partners of risk and to disclaim responsibility to prospective counterparties. Business innovators might therefore use the web to reduce their legal risk.

This blog post presents an advanced idea. To explain it will require space, so please hang with me as I lay out my argument. First I will explain how forward-thinking traders like hedge funds can be exposed to new legal liability. Then I will explain a method for containing that exposure, a method that could apply to more than just hedge funds and financial markets.

The legal desire to warn others and disclaim liability is acute in the cutthroat world of financial derivatives and structured finance. Derivatives (which are fueled by efficient digital technology), especially credit default swaps (CDS), allow aggressive traders to assume unconventional, counterintuitive positions – positions that may surprise and even anger other parties. Three examples:

1. George Soros says some of the bondholders in the AbitibiBowater and General Motors bankruptcies perversely preferred to dissolve the companies rather than reorganize them on account of the bondholders’ positions in credit default swaps. “CDS are instruments of destruction that ought to be outlawed,” he proclaimed (emphasis added). Further, to hold both a bond and a corresponding CDS simultaneously “is like buying life insurance on someone else’s life and owning a license to kill him.” George Soros, “My three steps to financial reform,” Financial Times, June 17, 2009.

2. Some analysts complain about a Fidelity mutual fund that simultaneously held both bonds issued by the distressed Six Flags company and hedged CDS positions relative to those bonds. According to the analysts, the mutual fund turned down a reasonable restructuring offer for the Six Flags company. Strangely, the mutual fund preferred that Six Flags sink into bankruptcy where bondholders as bondholders would receive less. The Economist magazine goes on to observe, “By purchasing a material amount of a firm’s debt in conjunction with a disproportionately large number of CDS contracts, rapacious lenders (mostly hedge funds) can render bankruptcy more attractive than solvency.” “CDSs and bankruptcy: No empty threat,” The Economist, June 20, 2009, p. 79 (emphasis added to highlight that the Economist thinks the mutual fund's behavior was bad and presumably should be punished).

3. Amherst Holdings, a Texas investment firm, “ambushed” some big banks. The banks were counterparties to which Amherst had sold CDSs so that the banks could hedge their losses on bonds they owned representing defaulting mortgages. From the sale of the CDSs, Amherst and its associates earned multimillion dollar fees from the banks. Under the terms of the CDSs, team Amherst would have to pay handsomely as the losses from the defaulting mortgages were allocated under the bonds to the banks. But then Amherst executed a maneuver that prevented the banks from collecting under the CDSs. It used a little-known legal loophole to arrange (with the party that services the bonds) for the bonds to be paid in full! The banks were not prepared for this scenario. The result was that team Amherst did not have to pay as expected under the CDSs. On balance, Amherst made money, and the banks lost the substantial fees they had paid team Amherst for the CDSs. Some of the banks have complained to industry trade associations that Amherst acted improperly. Zuckerman, Ng & Rappaport, “A Daring Trade Has Wall Street Seething,” Wall Street Journal, June 12, 2009. Deutsche Bank averred that a maneuver like Amherst’s might be illegal.

In each of these three stories, counterparties or other investors felt the successful traders had acted unfairly, possibly deceptively and perhaps even illegally.

When large sums of money are lost unexpectedly, losers are prone to seek legal or political redress. They might try to claim, for example, that they were victims of fraud or that they were entitled to more disclosure of the other party’s intention, position, or strategy.

But in anticipation of the possibility of such legal claims, unconventional traders might take steps long in advance. They might pre-empt such claims by issuing a general warning and disclaimer. They might conspicuously publish on their Web pages a notice like this:

“Notice. This is notice published by ABC Hedge Fund (the “Fund”) to the attention of any party that may have a direct or indirect relationship to the Fund’s investments, including but not limited to an investor, a counterparty or the issuer of debt, equity or other rights, interests or securities. Please be advised that the Fund may assume or take advantage of innovative, unconventional or surprising positions. While the Fund shall always stay in full compliance with all applicable laws, please be alert that the Fund may aggressively pursue trading or investment strategies that are novel or counterintuitive. Except to the extent the Fund otherwise explicitly agrees in writing, the Fund disclaims responsibility to (a) inform others of its intentions, trading positions or investment strategies, or (b) look out for the interests of others or divine their intentions, strategies or expectations.”

Publication of such a notice/disclaimer would create electronic records suggesting that prospective “victims” had been warned in advance.

How effective might such a notice be? Although the legal effect of any kind of disclaimer can rarely be certain for all circumstances, support is growing for the proposition that general-distribution legal notices can be delivered by way of publication on the web. Observe four angles on the topic: